There's a trade-off when minimizing risk

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Terry SavageThe Savage Truth

What’s your appetite for risk?

When choosing food at a buffet, your appetite might increase at the sight of all the offerings, even though you thought you weren’t very hungry. The same is true with the stock market. All those headlines about stocks making new highs, with gains and profits so easy to grab, may have overwhelmed your sensible appetite for risk.

Now comes the indigestion. Only when the market goes against you do you really understand how scary it can be to lose some of your money. Wall Street took a tumble early this month, and the selling resulted in two 1,000-point drops that left the Dow in a correction, a 10 percent decline from previous highs.

But it’s important to keep that in perspective.

If you’ve been contributing to an investment account since 2009, those purchases are likely still up 250 percent. But if you were among those investors who poured billions of dollars into the market in January, buying stocks and mutual funds at the top (so far), then you likely have a very different perspective.

Perspective is essential

In assessing risk, perspective is one key ingredient. In stocks, the risk is obvious, and more so in hindsight. In January, many felt the economy was growing, the tax bill would create more profits and that stocks were the place to invest.

Nothing fundamental changed about the economy in the past few weeks — not the outlook for corporate earnings or the federal budget or economic growth. We all know the Fed is on track to raise rates, and that a growing economy could ignite inflation. Yet the market suddenly swerved, taking with it all the gains of the first six weeks of the year, and more.

Assess risk in perspective

Most homeowners know the risk of loss that would occur if their house burns down, so they buy fire insurance. It’s a risk people don’t want to take.

How much risk are you willing to take with your own personal finances? If it’s a retirement account, the perception of risk is (or should be) magnified if you are closer to your planned retirement date.

A younger person logically thinks that retirement is a lifetime away, with plenty of time to recoup any losses. But if you have to start drawing on your accounts in a few years, the perceived — and real — risk of stocks is a lot greater.

Understand risk in the alternatives

Removing some of your money from the risk of equities still leaves you with a challenge: Where can you hide from risk? The simple answer is that every alternative also involves some risk, but of a different type.

For example, don’t think you can jump into bonds or bond funds as a safer alternative to stocks. All bonds, even the highest rated ones, will lose market value as interest rates rise.

The safest choice when it comes to risk is a short-term FDIC-insured bank CD or a money market account. But you barely earn any interest on those choices these days. That’s the trade-off for minimizing risk.

The essential element of risk is the understanding that no one knows for sure if, and when, the most disastrous risk will materialize. So stop watching TV pundits who claim to know all. Stop looking for chart signals and volatility indexes. Sure, they can help, but they can also confuse. And there is no guarantee they will be right.

Instead, stop and listen to your own inner voice, the one that tells you how your life would change if the worst potential risk comes true. Then make a rational, sensible decision, which is not a result of emotion. And don’t look back. That will let you sleep at night. And that’s The Savage Truth.

Terry Savage is a registered investment adviser and the author of four best-selling books, including “The Savage Truth on Money.” She responds to questions on her blog at TerrySavage.com.